BLAST 11 October 2017

11 October 2017

CryptoFinance Insights: Is Bitcoin money?

Gautam Chhugani +65-6230-4654 gautam.chhugani@bernstein.com

Gaurav Jangale, ACA +65-6230-4682 gaurav.jangale@bernstein.com

We aim to educate investors on the emerging world of Bitcoin and cryptofinance. We partner with a Cryptocurrency expert and investor AriPaul. Ari is the Managing partner and CIO of Block Tower Capital.

Bitcoin and its underlying blockchain technology has implications governments or monarchies issue currency with faces ofon business models across industries, particularly around Monarchs embossed on them. Understanding money backwardsfinancial services and payments. However, what we find more from today is a failed exercise to start with because ourinteresting is the relative value dynamics this industry is bringing understanding of money is overly obsessed with its currentabout between (deflationary) virtual currency and (inflationary) physical form and its authority from the sovereign state. As we gofiat currency. Bitcoin now trades at ~US$4,800 per Bitcoin with through the idea behind money, we will highlight a fewtotal market value of ~$80bn. It is worth delving into the very characteristics so that they can be compared with the big ideasnature and essence of Bitcoin to understand what drives its behind Bitcoin.value. Is it legal tender currency or an asset class comparable to thdigital gold? Or is it like the 17 Century Tulip Bulbs mania asclaimed by those who call it a fraud? As market cap of the crypto Economic exchange did not wait for currencytokens increases, does it have monetary policy, regulatory and The genesis of money lies in the concept of credit. Money beforegeo-political implications? Would Wall street allocate money to coinage was simply 'I owe you dues' (IOU) which would beCrypto assets? tracked using simple accounting records. The accountingAs we spent time understanding Bitcoin, we always came back to method could be simple records, tally sticks, stone markings.this tweet by one of the Bitcoin core developers: Economic exchange did not wait for coinage. People went about"First step to understanding Bitcoin: Admitting you don't trade they just recorded the value in rudimentary but effectiveunderstand Bitcoin. forms of record keeping. Coinage and standardized currencyFinal step: Realizing that "understanding" is a moving target." came in much later. Jameson Lopp (@lopp) February 8, 2017 For example, if A, a producer of wheat sold 1 kg of wheat to B. Suppose, B was a producer of oranges. The accounting recordsIn this note, we start with the most basic question Is Bitcoin would just keep track that B owes A, but not necessarily A wouldmoney? have to accept oranges in return. A is just assured that when he needs something, B would return the favour (in oranges or not).Do we understand money?To answer the question whether Bitcoin is money, we need to Literacy, numeracy and accounting was invented before money.first understand money. Our attempt to explain Bitcoin is Money was always imaginary (using a ledger) before we made itnecessarily constrained by our own conditioning and physical with coins and notes. This single big idea about money,understanding of the world we grew up in. The broad narrative carries the maximum freight to explain the current phenomenonwe have been taught is 'first there was barter and then came of virtual currencies which are simply decentralized ledgerscurrency to make it more efficient'. We have always seen secured using cryptography.

EXHIBIT 1: Is the conventional history of money just convenient logic?

Analyst Page Bernstein Events Industry Page

See Disclosure Appendix of this report for important disclosures and analyst certifications www.bernsteinresearch.comGautam Chhugani +65-6230-4654 gautam.chhugani@bernstein.com 11 October 2017

Coinage attempt to standardize, universal value

Bank money .with original function as account clearing between merchants

Source: Money: The Unauthorized Biography (Felix Martin); Debt: The First 5,000 Years (David Graeber), Bernstein analysisCredit and clearing systems existed before cash currency EXHIBIT 2: Stone used in Yap Island for recording duesPeople engaged in trade without barter and even before coinage.All they needed was a simple method of maintaining accountsbetween parties - a simple system of IOUs. History is replete withunique methods being used to keep tally accounts in form ofwhat we call a modern-day ledger. The ledger could bemaintained as markings on stones, wooden sticks, or evenmarkings on a wall or even large immovable stones which havevalue attributed in form of credit (see Exhibit 2)The system of IOUs have also been prevalent during recentperiods. When the Irish banks shut down for 6 months in 1970,the economy survived on a system of private cheques /IOUshouldered by neighborhood pubs. For 6 months, what workedwas a personalized credit system without any definite timehorizon for eventual clearance of debits and credits. In fact, evenduring recent demonetization in India in 2016, we heardanecdotes of goodwill ledgers beings used by businessmen tosettle accounts and continue trading. Source: Wikimedia CommonsIn many cases, the stone could be immovable but everyone wouldstill attribute credit to its rightful owner. (Stone used in Yap Island The myth of barterin Exhibit 2). The coins and currency are mere tokens to recordthe underlying system of credit and clearing. Currency is only The notion of barter evolving to money was a convenientcosmetic; it is the underlying system of credit and clearing that is assumption for thinkers and economists. People did not really tryfundamental foundation of money. Money in the museums has to exchange chickens for wheat because there were no matchingalways been shown in form of ancient coins in copper, gold and engines back then to solve the double coincidence of needs.silver. This vivid image of money has over emphasized the Instead, people starting storing goods of common use (e.g. salt)token/the currency and not the underlying mechanism around it. which everyone else finds useful and hence, commodities suchIf money was displayed in the museums as an old ledger, it as salt, sugar became convenient alternates to currency. Historyprobably would not be as interesting to look at. is filled with cases of salt, dried cod, sugar, hides, even nails being used as currency. Thus, currency in simple terms is something the society believes in to be acceptable universally. Currency evolved to metals for long distance trading as metals are durable, portable and divisible. Coinage was merely the

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process of standardizing and stamping the metals to be of Money, as we understand now has the following coredesignated weight and size. functionalities: Credit clearing mechanism or a simple ledger (often maintained by banks and intermediaries in modern times)Monetization, universal value and creation of markets Portable, durable, divisibleFor markets to function, there has to be a shared unit ofeconomic value so that participants know the language of Transferable, trust and faith (often comes from thenegotiation. Then came the process of tokenizing the coins with sovereign endorsement)standard attributed value (initial coins were just standard weight Standard universal value (though politics/economics/monetarysilver, but issued coins were for example 100 drachmas). policy has often impacted value of money by inflating (printing)Universal economic value is just a universal language to discuss /deflating money)the value of anything. Through this process of monetization,emerged the concept of 'market' as the organized principle ofprices and the language to express ambition, greed, and Bitcoin: Can you create value from thin air?entrepreneurship. Cryptocurrency (e.g. Bitcoin) is best understood in form of 3 layers:Transferability and negotiability Blockchain (ledger and clearing systems)Money is credit due (IOU) but it needs to be transferrable credit. Protocol (crypto based monetary policy and incentivesMoney has value, when you expect others to accept it. It needs to establishing trustless network)be transferable in an open market. Thus, for any party to acceptan IOU, there should be trust that any third party will be willing to Tokens (Portable, durable, divisible, transferable)accept the IOU i.e. there is a liquid market for it to betransferable. Thus, appeared bank money. Banks in their earlyforms became clearing house of debt between merchants. Blockchain the ledger and clearing systems The blockchain is a shared ledger, which keeps a permanent, immutable record of digital transactions. The ledger isOnset of bank money with trust being reposed in centralized decentralized i.e. a copy of the ledger is maintained acrossbanks multiple computers across the globe. The Computer nodes areBanks first started as merchant clearing houses. Once a bank called miners; it would be easy to think of them as book-keepershad endorsed the credit/IOU, it would become transferable in who verify the transactions and agree on the state of the ledgerthe market based on the faith in the large clearing houses. In that needs to be carried forward. For performing the ledgersimple terms, Banks could issue IOU to depositors and receive verification service or the bookkeeping services, they areIOU in form of receivables. We look at banks as lending rewarded in Bitcoins (also called mining Bitcoins).organisations today, but banks' original function was this clearingfunction. The protocol the new crypto based monetary policy Protocol is a set of rules that nodes in a network use to transmitRole of the sovereign state information. Transmission control protocol (TCP) is the set ofAs we have seen by now, money is a system of credit, that is rules to exchange information packets on the internet. Theliquid, transferable and trustless. Sovereign states became more Internet protocol (IP) is the set of rules to exchange messages atimportant, maintaining large armies, protecting societies and the internet address level.thereafter provision of public goods and services against which In the context of blockchains and particularly Bitcoin, becausethey would collect taxes. Sovereign governments (regardless of the information is a form of digital financial transaction, theform) became a significant part of the national output and thus protocol becomes a set of rules to govern the identity, security,largest source of payments in the economy. economic incentives of the digital transactions on the BitcoinThis economic prominence of the sovereign state only meant that network. The identity and security of the transactions and themoney issued by the sovereign facilitated the trustless, liquid ledger is established through cryptography both at the accountmarket where the citizens would trust the money issued by holder level (through public/private key crypto rules) and at thesovereign. Today, we assume that currency needs to be issued level of Miners/book-keepers to maintain security andby the sovereign state; however, it is not the sovereign stamp, but authenticity of the ledger simple to build consensus on thethe trust and universal acceptability feature that gives currency state of the ledger. These set of crypto-economic rules could beits value. seen as the new monetary policy. Further, the Bitcoin blockchain

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is so designed that the supply is capped at 21 million bitcoins

(with the maximum supply reached in the year 2140). There are What gives bitcoin value?currently ~16.6 million bitcoins with an exponentially decreasinginflation rate thus the bitcoin protocol is considered to be Its tempting to value Bitcoin relative to companies ordeflationary in nature. commodities with related value propositions. The value of top 4 global payment networks aggregates to ~$550 bn; the worldsThe trust, security and transferability of the Bitcoin come from gold supply is worth roughly $7 trillion vs. Bitcoin's market cap ofthe set of crypto-economic rules that are part of the Bitcoin ~$76 bn. While these comparisons are useful starting points,protocol. It clearly obviates the need of a central authority to they fall short.validate transactions centrally.

Monetary transmission or a new economy?

Tokens are like bearer cash Some of Bitcoins value does indeed come from its usefulness forThe token native to the Bitcoin blockchain network is called payments or monetary transfer. Early advocates of BitcoinBitcoin. Other blockchains can have their own tokens e.g. Ether suggested it would be adopted by merchants to avoidis the intrinsic token to the Ethereum blockchain network. Tokens chargebacks, or that it would displace traditional money transferare used as economic incentives/disincentives to reward the services by providing cheaper and faster remittances. Bitcoinminers / users as part of the network. currently allows the user to transfer large amounts of money in thThe Bitcoin token is divisible to the 8 decimal. It functions as about 10 minutes for about $2, an attractive alternative to wirebearer cash. You just need to know the public address of the transfers or international remittance services. However, nothingreceiver to send it it is permission-less just like how cash prevents existing financial institutions from offering even fastercurrency is in the physical world. If you want to buy anything off and cheaper transmission services. Bitcoin is valuable in thisthe shelf, you just need to hand over the cash. Similarly, to regard only for censorship resistance. Payment networks cantransfer Bitcoin, you just need to know the public address of the block payments to a particular company for example and bankreceiver. The white paper on Bitcoin by Satoshi Nakamoto regulators can ban wire transfers to a particular country or(unidentified individual or a group) refers to Bitcoin as electronic company. In contrast, it is near impossible to prevent an owner ofpeer to peer cash. It intends to build a mechanism to make bitcoins from transferring them to a third party of their choice.payments over a communication channel (just like we send In fact, Bitcoin could be seen as virtual 'bearer cash' economyinformation on the internet) without a centralized trusted third supported by a decentralized 'trustless' network a new cryptoparty. economy with its own protocol or policy. The faith of its citizens software developers, miners, investors, early individual and sovereign state adopters would drive the value of that network.Governance issues in absence of central authority The value of the new economic network can be related to theTo change or upgrade the Bitcoin network software sometimes transactions in the network as reflected in Exhibits 3 to 4requires a hard fork. A hard fork is a change in the networkprotocol that renders it incompatible with older versions of thesoftware. A hard fork may be uncontentious and viewed as a Bitcoin could fluctuate daily (as high as 5-10% per day) for it towelcome software upgrade by the entire community, or it may be be stable money, although it is in its early days. Fiat money is stillcontentious. In a contentious hard fork, some people running the final form of settlement governments still collect taxes inBitcoin software may install new incompatible software, while fiat money and salaries are still paid in fiat money. Thus, for nowothers remain on the old network; this can result in two Bitcoin has only emerged as a 'censorship resistant' asset class.competing blockchains that are forks of the previous chain. On st We will delve deeper into Bitcoin and its cryptographic cousins inAugust 1 , Bitcoin forked into Bitcoin and Bitcoin Cash. In the coming editions.November, there may be another fork in which there may be twoblockchains each claiming to be Bitcoin. Some investors fearthis could produce confusion and hurt investor confidence, whileothers see it as the cost of decentralized governance.

While, it emerges that Bitcoin does share some of the core

functionalities of money secure clearing mechanism, divisible,portable, transferable, secure and trustworthy (crypto-economicrules), the most intriguing part is its value? How do we know it isworth ~$4,800 as it stands today?

MXAPJ base year is 2016;.

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VALUATION METHODOLOGYIndia FinancialsIndia is a growth market and investors generally seek growth-based returns in India. We believe all banks in India trade on what marketbelieves as the sustainable earnings growth momentum. Banks that have sustained cross-cycle earnings growth despite sector assetquality concerns trade at a premium. On the other hand, banks that have been inconsistent in earnings growth get penalized by the marketuntil they build investor confidence again. We value our coverage on a target P/E multiple based on one year forward earnings calibrated bytrading history and our expectation of three-year sustainable earnings growth. We use a one-year forward multiple based on FY'19 earningsto arrive at FY'18 end target price. We corroborate our target price earnings multiples with a P/BV based multiple as a secondary check. Wealso believe the market can be brutal with growth stocks if the growth story shows any structural weakness and thus we constantly stress-test for structural growth weakness across our industry and company investment thesis. This methodology works for banks under NPLstress too as we expect earnings to largely normalize by FY'19

RISKSHDFC Bank Ltd HDFCB faces significant margin pressure beyond our expectations in line with industry trends HDFCB is unable to drive operating leverage and scale across its retail lending business to enable significant costs savings in operating expenditure HDFCB has to meaningfully slow down credit cards and personal loan book growth due to unexpected risk concerns

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